The Problems of Excess Chinese Debt

Alice laughed. “There’s no use trying,” she said: “one can’t believe impossible things.”“I daresay you haven’t had much practice,” said the Queen. “When I was your age, I always did it for half-an-hour a day. Why, sometimes I’ve believed as many as six impossible things before breakfast.” (Alice Through the Looking Glass)

Objective

This article looks at some of the issues surrounding Chinese debt, and questions where China will now go. No one can be authoritative on this subject, unless they believe six impossible things before breakfast, but my intention is to contribute to a discussion.

China is a Managed System

The question of excess Chinese debt has attracted much attention over the last two years, but it seems that most authorities are in disagreement as to its effect, and the factors driving it. It is an enigma, because the normal logic, which applies in Western capitalist economies does not apply in China. China is a controlled economy, and the Chinese Communist Party determines policies, sets targets for example for GDP, which are followed, and then finds it difficult to reconcile the effects of different policies. However, it is important to remember that in China politics will always be paramount; that is the survival of the Chinese Communist Party, not the rule of law, regulations, or economics. This is a managed, not an open, system. One example is the reluctance of the Chinese Communist Party to close down unprofitable and non-performing (zombie) State Owned Enterprises (SOEs), which employ large numbers of people. There is a real fear that such policies would create wide-scale social unrest, a threat to the party.

State Owned Enterprises

According to the World Bank, in 2010 SOEs still controlled a substantial part of the Chinese economy, approximately 30% of all secondary and tertiary assets, and over 50% of total industrial assets. The average size of SOEs was much bigger than their non-SOE peers, over 13 times larger on average.[1] This was after an earlier programme of reform which had seen SOEs reduce their share of Chinese economic assets from nearly 70% in 1999. In 2013 President Xi Jinping announced that he was going to reform state-owned enterprises, but in 2016 Bloomberg found that, “Outside of utilities like China General Nuclear Power, practically every part of China’s economy touched by state ownership has serious issues, either in terms of the amount of debt companies owe or investor returns. Even tech outfits score low on profitability and return on assets.”[2] Return on assets has fallen in most industries, the Chinese economy faces an enormous glut from uncontrolled over-production. The State Council said in January 2012 that it planned to cut steel production capacity by 100 million to 150 million tons, without specifying a time frame. IHS Global Insight claims that China’s steel producers lost an estimated $12 billion in 2015. In addition, according to Bloomberg, many “Chinese companies, especially swollen real-estate developers, have huge assets supported by a tiny sliver of equity.”[3]

In many respects, you can see the modern Chinese economy as a rerun of the Sorcerer’s Apprentice, which was part of the Disney film Fantasia in 1940. In the film Mickey Mouse cannot control the water coming from the many buckets he has created by magical means. There are two consequences that result from China’s unprecedented level of investment, firstly, industries like steel have now reached levels of production, which cannot be supported by the Chinese economy, their profitability has therefore fallen, and their debt payments have risen; they have the same problem as Mickey Mouse. The second consequence, is that much of the investment has been made in non-performing assets, the “ghost cities“, which have no population, are an obvious example. I also remember an anecdote from a businessman, he and his colleague booked into a hotel near to Beijing, on the first day they chose one of the five restaurants, apart from themselves there were no other guests, the next day they eat at another restaurant in the hotel, it was also empty, they then asked how many guests were staying in this hotel, which had a 1,000 bedrooms; they were the only guests. It is not an exaggeration to say that China has invested in huge numbers of empty apartment buildings, airports which can only serve a handful of customers, railways to tiny communities, and bridges to nowhere.

The Chinese economy has become addicted to the creation of assets which will never return profits, or in any way justify the capital spent on them, and it is the debt servicing of such projects which hangs like an albatross around the neck of the Chinese economy. In order to raise additional capital, Chinese institutions have many cases issued fraudulent bonds, or an effect engaged in Ponzi schemes. Chinese courts and regulators have normally blamed individuals, rather than the banks they work for, where such cases have come to public attention, but this is not due merely to local corruption, this is a systemic problem, which lies at the heart of the Chinese economy.

David Lipton of the IMF took a robust view of the situation in a speech he gave in Shenzhen in June 2016. He noted that Chinese corporate debt at about 145% of GDP, “is very high by any measure.” He added, “By IMF calculations, state-owned enterprises account for about 55 percent of corporate debt. That is far greater than their 22 percent share of economic output. These corporates are also far less profitable than private enterprises.”[4] He added, “The past year’s credit boom is just extending the problem. Already many SOEs are essentially on life support.”

Chinese state companies, and local government authorities, have issued enormous quantities of bonds, and other financial instruments, the only purpose of which is to keep alive non-performing state companies, or to undertake large-scale development in cities and regions; investments which are unlikely to generate sufficient profits in future years in order to cover their interest charges.

Large-scale corruption at local government level, in particular connected with housing and other forms of property development, has benefited officials, who are well paid by developers for their cooperation and support in removing peasants from farmland and granting planning approvals. This behaviour has also been driven by Communist Party policy to promote growth at local level. Much of the capital flight of recent years has been driven by corrupt officials, moving their gains to Hong Kong, and then to countries like Canada and Australia.

China’s Growing Indebtedness

To the outsider the rapidly escalating levels debt in China are a paradox, it is difficult to see why, if China is really a very successful economy, as is often maintained, generating large amounts of profitable exports, and sizeable inward investment. But the reality is that the Chinese economy is unbalanced, and that large parts of it are dysfunctional. China today can be compared to an American householder, whose income is inadequate to support his lifestyle, and who resorts to maxing-out a series of credit cards, or even borrows from a payday lender. There can be no happy ending in such a situation.

As the IMF noted in 2017, “Since the global financial crisis, China’s growth has relied increasingly on credit, especially in the corporate sector, including state-owned enterprises, and in recent months also on mortgage lending. Tensions between sustaining growth and the need to contain indebtedness, together with certain financial sector innovations, have led to increased financial sector complexity and the risk of gaps in supervision.”[5]

Data from the Institute of International Finance suggests that China’s total debt passed 304% of GDP in May 2017. According to the IMF, in China, “Credit growth has outpaced GDP growth, leading to a large credit overhang. The credit-to-GDP ratio is now about 25 percent above the long-term trend, very high by international standards and consistent with a high probability of financial distress. As a result, corporate debt has reached 165 percent of GDP, and household debt—while still low—has risen by 15 percentage points of GDP over the past five years and is increasingly linked to asset-price speculation. The buildup of credit in traditional sectors has gone hand-in-hand with a slowdown of productivity growth and pressures on asset quality.”[6] The IMF added, “some of the underlying causes of risks are yet to be fully addressed, reflecting policy tensions. These are: first, the overriding objective, especially at the local government level, to achieve high growth rates that encourages credit expansion, particularly in the shadow banking sector; second, complexity and opacity of the financial system—reflecting rapid growth and development, as well as regulatory arbitrage—undermine the authorities’ ability to measure asset quality, and to assess and mitigate risk; and third, the existence of implicit guarantees encourages moral hazard and excessive risk taking on the part of households, corporates, local governments, and financial institutions.”[7] In addition, the IMF also acknowledged that regulators were subject to political direction, lacking independence, and that this was a serious weakness, as the December 2017 Report said, “three critical gaps common across China’s regulatory agencies exist: lack of independence; insufficient resources for supervising a large and increasingly complex financial sector; and inadequate interagency coordination and systemic risk analysis. These gaps have been fundamental in contributing to the build-up of financial risks.”[8]

A Ponzi scheme?

According to the Chairman of the Bank of China, Xiao Gang, writing in October 2012: “China’s shadow banking sector has become a potential source of systemic financial risk over the next few years. Particularly worrisome is the quality and transparency of WMPs. Many assets underlying the products are dependent on some empty real-estate property or long-term infrastructure, and are sometimes even linked to high-risk projects, which may find it impossible to generate sufficient cash flow to meet repayment obligations. Moreover, many WMPs are not even linked to any specific asset, rather, just to a pool of assets, whose cash inflows may often not match the timing of scheduled WMP repayments.” He added, “In fact, when faced with a liquidity problem, a simple way to avoid the problem could be through using new issuance of WMPs to repay maturing products. To some extent, this is fundamentally a Ponzi scheme. Under certain conditions, the music may stop when investors lose confidence and reduce their buying or withdraw from WMPs. The rollover of a large share of WMPs could weigh heavily on formal banks’ reputations, because many investors firmly believe that banks won’t close down and they can always get their money back.”[9]

Non-Financial Debt

The scale of the increase in non-financial debt is captured by the IMF chart below, December 2017:

Wealth and Asset Management Products

Bloomberg estimated that, as of June 2016, Chinese asset-management products (AMPs), mostly held off-balance sheet, were worth $8.7 trillion (75% of China’s GDP); wealth management products (WMPs) were worth $3.8 trillion, or $12.5 trillion in total. Approximately 25% of WMPs are invested in property and construction, sectors vulnerable to market corrections. WMPs are also investing in each other, generating increased systemic risk.[10]

In November 2017 China’s regulators announced that they will overhaul the regulation of asset management products, which are worth about $15 trillion, and the authorities have recently acted against some obvious scans, including the issue of fraudulent letters of guarantee by the staff of Guangfa Bank in Guangdong. According to The South China Morning Post the case involved as much as 12 billion yuan (about $1.8 billion), “as the bank tried to channel money to cover its mounting bad loans and operational losses.” China Minsheung Banking Corporation was also fined, in another case, for selling fake wealth management products. Foresea Life Insurance and Anbang, were also banned, earlier in 2017, from issuing new products.

The China’s financial system has developed rapidly in size and complexity, and is now as one of the world’s largest with financial assets at nearly 470% of GDP.

Although a tougher regulatory regime may, from a Western perspective, seem necessary and even essential, in order to stop the issuance of further bad debt, and unsupported bonds, there is, however, a problem if the introduction of a tight system of regulation creates systemic losses in China’s banking system and non-financial bond market. As Michael Pettis noted, “deregulating an insolvent banking system will likely lead mainly to a multiplication of bad debt.” Over the last few years China, as a matter of policy, has chosen to accelerate credit, rather than to see a reduction in its growth rate, but it is possible that China will soon face a limit to its debt capacity, which will not only reduce its growth rate, but may well generate a full-scale financial crisis within China, as implicit guarantees are removed, and the fraudulent nature of much of the debt is exposed. So, the regulators are likely to be reined in, once it becomes clear how much of China’s economy could be threatened. On the 8th December 2017 Reuters reported that ten Chinese joint stock banks raised strong objections to the tightening of control over the asset management sector. The bank executives said that stronger regulations would have a large impact on the financial markets and could even “trigger systemic financial risks.”

There are no signs that the Chinese government understands how it can rebalance its economy to move wealth from local government, failing state enterprises, and property companies to the household sector. While it is impossible that China can continue to support its current financial system indefinitely, it is not obvious how the Chinese government can change policy at this stage, without creating and era of stagnation similar to that experienced by Japan in the 1980s. Although the World Bank believes that Chinese growth can remain above 6 1/2% for the next 20 years, I believe that this is actually impossible, and that at some time within the next few years Chinese growth will collapse, to levels of around two to three percent p.a.

The behaviour of companies like Foresea Life Insurance and Guangfa Bank are in no way unique, but are representative of the general behaviour within the Chinese financial markets. The issuance of wealth management products with guaranteed returns, are in the words of the Chairman of the Bank of China – “To some extent, this is fundamentally a Ponzi scheme.”

There are two other important points to make, one is that the problems with corruption are not the case of a few bad apples, this is a systemic problem, common throughout the Chinese economy; it is a natural outcome of the circumstances and policies. The second point, which was made in the Oxford Review of Economic Policy in 2016, was that over the last 10 years much of the investment made by China is actually been in non-performing assets, that is investments which will never pay the capital and interest expended on them, and which will become a drain on the country’s economy as China struggles to repay these immense capital costs. As the authors of the paper conclude: “The question of whether infrastructure investment leads to economic growth must be answered in the negative. Owing to uncertainty surrounding costs, time, and benefits parameters, a typical infrastructure project fails to deliver a positive risk-adjusted return. There is a common tendency for the benefit-to-cost ratio of major infrastructure investments to fall below 1.0. Such unproductive projects detract from economic prosperity. We thus reject the orthodox theory that heavy investment in infrastructure causes growth.”[11] On this basis, the planned investment in the One Belt One Road is unlikely to benefit China.

I do not believe that China is going to collapse, although over the next few years the control of the Chinese Communist Party will be challenged; rather China may follow the Soviet Union, or Japan, into stagnation and loss of value. Western policy should be cautious, there is no need to challenge China; it has very serious problems of its own, and it is in the interests of the global economy that China stabilizes in such a way that it does not generate a systemic global impact. China will remain an important part of the global economy, but the glory days of double-digit growth are now over, and the prices of raw materials will stabilize at pre-boom levels. China is a much more troubled and unbalanced economy than most outsiders understand. Excessive investment means that China’s productive capacity, especially in core products like steel and ship building, now greatly exceeds demand. China has not acted effectively to reduce this excess capacity; this sets the scene for dumping in foreign markets, and arguments at the WTO.

It is worth bearing in mind that China and Hong Kong both performed badly as regards BIS’s 2017 stress indicators in domestic banking systems, with Credit-to-GDP gaps of 24.6 and 30.3 respectively, the highest for any major economy.[12]